Plosser’s Limited Fed: A Statesman Takes a Stand
by Doug Noland
November 22, 2013
The stock market melt up continues. Meanwhile, intrigue only grows at the Fed. November 19, 2013: “From NPR News, this is All Things Considered. I’m Robert Siegel. And I’m Melissa Block. Americans are utterly fed up with Washington. That’s the takeaway from the latest round of public opinion polls. Approval ratings for just about every leader and political institution from the president to Congress are now at record lows. NPR’s national political correspondent Mara Liasson reports on why and what the consequences might be. Bill McInturff, the Republican half of The Wall Street Journal/NBC polling team calls it a public opinion shockwave. He’s never seen voters express such disgust at both parties and their leaders. Bill McInturff: ‘October was one of the most consequential months in the last 30 years in American public opinion. And the consequences are all negative. The President’s job approvals hit a new low. His personal approvals turned negative for the first time. Republicans became the first political party with a 50% negative and every person in the Congressional leadership hit new highs in their negatives. No one was spared. America’s fed up and very tired of what happens in Washington.’”
These days I think often of Adam Fergusson’s classic “When Money Dies: The Nightmare of Deficit Spending, Devaluation, and Hyperinflation in Weimar Germany.” One of the more fascinating and pertinent aspects of Fergusson’s historical account was how monetary policymakers somehow remained oblivious to the havoc they were instrumental in fomenting. Throughout the ordeal, top central bank officials believed monetary policy was responding to outside developments instead of being a root cause of deleterious processes that ended up tearing society apart. Despite what should have been an obvious disaster in the making, the central bank succumbed to constant pressure from various constituencies to step up its money printing operation.
Americans’ confidence in its politicians is at a multi-decade low. The popular refrain remains “Thank God for the Federal Reserve!” Somehow, it goes unappreciated that flawed monetary doctrine has been instrumental in fomenting societal stress, divisiveness and the steady erosion in the public’s faith in its institutions. A multi-decade period of unsound “money” and Credit has fueled an ongoing perilous cycle of asset Bubbles, booms and busts, gross misallocation of resources with resulting economic stagnation, and inequitable wealth distribution on a historic scale. Unfettered “money” and Credit on an unprecedented worldwide basis have been responsible for unmatched global financial and economic imbalances, including the deindustrialization and ever-growing debt overhang that hamstrings the U.S. economy. While it is difficult to hold much sympathy for today’s politicians, I’d argue strongly that years of unsound finance is at the root of today’s increasingly dysfunctional political landscape.
Fundamental to my “Granddaddy of all Bubbles” thesis are the momentous risks associated with governments’ and central banks’ reflationary policymaking – a policy course that for five years now has inflated the expansive “global government finance Bubble.” QE (“money”-printing) cost vs. benefit analysis has turned more topical of late. Again this week, top Fed officials (Evans and Rosengren) argued that QE benefits greatly exceed “marginal” potential costs. History will not be kind. At the end of the day, the loss of confidence in the Fed and central banking more generally will come at a very steep price.
In the spirit of “When Money Dies,” it is unwise for Fed officials to be so dismissive of the costs associated with its experiment in inflationary monetary policy. After all, monetary inflations unleash processes that are unpredictable both in course and eventual outcome. I adhere to the view that asset inflation is potentially more dangerous than traditional consumer price inflation.
Can the Fed actually wind down QE? Or is the Fed’s (prisoner to dysfunctional markets) balance sheet on its way to $10 TN? What would be the consequences? Fed officials have no idea at this point how any of this will play out. Indeed, I’ve seen no indication that they have much understanding of the impact of QE to this point – even with the benefit of hindsight. Officials seem to suggest that expanding the Fed’s balance sheet to almost $4 TN has had only modest impact other than to somewhat force long-term interest rates lower. At least publicly, they’re sticking with the story that so long as their QE “money” sits idly on the banking system’s balance sheet as “reserves” it’s having minimal inflationary effect. It’s just not credible that, with the Fed pumping “money” directly into the securities markets, the focus of cost analysis would remain on consumer prices rather than the myriad distortions and maladjustment associated with asset inflation and speculative Bubbles.
As master of the obvious, I would argue that QE has had profound, albeit disparate, impacts primarily on the financial markets. Moreover, the key is to appreciate that the effects of liquidity injections into the marketplace significantly depend on the prevailing market dynamics at the time. In this regard, there are important differences between “QE1,” “QE2” and the ongoing “QE3.”
“QE1” saw the Fed’s balance sheet expand from about $900bn in September 2008 to end ‘08 at almost $2.3 TN. De-risking and de-leveraging were the prevailing market dynamics at that time. Importantly, it was not a case of the Fed unleashing $1.4 TN of liquidity upon the real economy or even the financial markets. Basically, “QE1” accommodated a transfer of bond/MBS holdings from leveraged players (Wall Street firms, banks, hedge funds, mortgage REITs…) to the Fed’s balance sheet. From a cost/benefit perspective, one can argue that the “QE1” was instrumental in stemming a potential daisy-chain collapse of major financial institutions along with the global derivatives “marketplace” more generally.
“QE1” benefits were readily apparent, while most would argue the costs were minimal. I would counter that myriad associated costs were enormous if not evident. “QE1” was instrumental to the ongoing general expansion in global Credit and speculative excess, including the further ballooning of the “global leveraged speculating community” and global market and derivatives Bubbles more generally. “QE1” stopped in its tracks what would have been a painful but healthy cleansing of an “inflationary bias” and financial market speculation infrastructure that have been flourishing for the past twenty years. “QE1” also reversed what would have been a major restructuring of our services/consumption-based economy – and we would have been in a better place today because of it.
I’ll concede that the original QE was likely necessary to forego major financial and economic restructuring. Yet it was then critical for a diligent Fed to be on guard against speculative excess - rather than actively spurring speculation and asset inflation.
“QE2” saw the Fed’s balance sheet expand from $2.3 TN in October 2010 to $2.9 TN by June 2011, with market impacts pushed well into 2012 by an additional $400bn of long-term Treasury purchases associated with “Operation Twist” (Fed sells T-bills and buy bonds). To be sure, “QE2” pushed already potent “inflationary biases” to dangerous extremes. After trading as high as 3.6% in early 2011, 10-year Treasury yields sank to 1.45% in May of 2012. Benchmark MBS yields dropped from 4.40% to as low as 1.82%. Government, mortgage, corporate and municipal bond yields collapsed (prices spiked higher) as hundreds of billions flooded into myriad fixed-income funds and instruments.
It's certainly worth noting that “QE2” was instrumental in the surge of destabilizing late-cycle “hot money” flows into emerging market (EM) economies. International Reserve assets (indicative of EM inflows) jumped from about $8.6 TN in October 2010 to almost $10.5 TN by June 2012. It remains too early to gauge the true cost of “QE2” in terms of fixed-income excesses and EM financial and economic Bubble distortions. But the impacts were enormous and clearly of an altogether different nature than “QE1.”
The Fed began talking open-ended QE late in the summer of 2012. They claim it was in response to a stubbornly high US jobless rate. I still believe it was more related to acute global financial fragilities. The Fed’s balance sheet began 2013 at about $2.9 TN. Today it’s almost a Trillion higher, in by far history’s largest ever direct injection of central bank liquidity into the financial markets. As always, it’s fascinating to follow how speculative dynamics play out in the markets. With cracks surfacing in both bond and EM Bubbles, the prevailing 2013 “inflationary bias” shifted overwhelmingly (perhaps fatefully) to equities.
As an illustration, follow the trail of outflows from a somewhat less popular “Total Return Bond Fund” (TRBF). To fund outflows, TRBF sells Treasuries to the Federal Reserve. TRBF then transfers Fed liquidity to exiting investors that then use this “money” for investment in the now extremely popular “Total Stock Market Index Fund”. This fund then takes this “money” that originated with the Fed and bids up stock prices.
Or, how about an example where a hedge fund moves to exit an underperforming emerging bond market. Here the fund is unwinding a leveraged “carry trade” that involves selling the EM bond and liquidating the EM currency position. With the EM bonds and currency under intense (“hot money” outflow) pressure, the local EM central bank intervenes with currency purchases (sells dollars to buy the local currency). To fund these purchases, the EM central bank sells Treasuries to the Federal Reserve. The central bank then uses Fed liquidity for purchasing currency from the hedge fund, and the hedge fund then has “money” to rotate into 2013’s speculative vehicle of choice - US equities.
Any serious discussion of QE costs would now have to also consider the risks associated with a full-blown equities market Bubble. And, from my perspective, the Fed’s QE-induced equities Bubble joins a historic fixed-income Bubble to achieve virtually systemic distortion in the pricing and risk perceptions of financial assets generally. If Fed officials actually attempted a cost benefit analysis prior to commencing “QE3”, I seriously doubt they contemplated a 40% surge in the broader U.S. stock market.
It seems an increasing number of Fed officials recognize the need to rein in the growth of the Fed’s balance sheet. As Federal Reserve Bank of Atlanta president Dennis Lockhart (under)stated Friday: “There is a fair amount of uncertainty related to the longer-term consequences of growing the balance sheet. There could be some things that happen that are unanticipated.” You think?
I would also like to draw attention to a paper presented last week (Cato Institute’s 31st Annual Monetary Conference) by Federal Reserve Bank of Philadelphia President Charles Plosser, “A Limited Central Bank.” Mr. Plosser’s exceptional analysis is music to my analytical ears and has provided a glimmer of hope that some learned Statesmen will rise up and ensure this monetary inflation doesn’t spiral completely out of control. I can only hope his paper becomes a rallying cry throughout the Federal Reserve system.
From the “highlights”: “President Charles Plosser discusses what he believes is the Federal Reserve’s essential role and proposes how this institution might be improved to better fulfill that role. President Plosser proposes four limits on the central bank that would limit discretion and improve outcomes and accountability. First, limit the Fed’s monetary policy goals to a narrow mandate in which price stability is the sole, or at least the primary, objective; Second, limit the types of assets that the Fed can hold on its balance sheet to Treasury securities; Third, limit the Fed’s discretion in monetary policymaking by requiring a systematic, rule-like approach; And fourth, limit the boundaries of its lender-of-last-resort credit extension. These steps would yield a more limited central bank. In doing so, they would help preserve the central bank’s independence, thereby improving the effectiveness of monetary policy, and they would make it easier for the public to hold the Fed accountable for its policy decisions.”
Mr Draghi’s plea came as the eurozone’s PMI surveys for November came in weaker than expected, with the added twist that Germany is vastly outperforming France. “It is extremely disappointing and worrying. Recovery will remain tortuously slow,” said Howard Archer from IHS Global Insight.
Any such relapse would be a serious blow to president François Hollande, who trumpeted earlier this year that the crisis was over. Mr Hollande’s approval ratings have dropped to 20pc, the lowest of any French leader in modern times.
Jean-Michel Six from Standard & Poor’s said France is lagging the whole eurozone and is rapidly losing export share to Spain, where costs have been slashed.
“The Spanish are producing same kind of goods in automotive components and other sectors as the French, but they are much more competitive. You can’t blame France’s problems on the strong euro. Spain uses the same euro,” he said.
Mr Draghi said low inflation in the eurozone is complicating efforts by Club Med crisis states to carry out internal devaluations within EMU to regain competitiveness, while at the same time controlling their debt trajectories.
“If average inflation is allowed to drift too low at the euro area level, it is much harder for those countries to undershoot the average. Adjustment runs into major head winds as demand suffers and real debt burdens rise,” he said.
The comments follow warnings this week by the OECD watchdog that the eurozone’s crisis policy cannot work unless there is more stimulus in Germany and the eurozone core to balance the adjustment.
It said the attempt to drive down wage costs across Southern Europe through deflation is leading to a debt trap, and is in contradiction with the other objective of controlling debt ratios.
This critique has been made by leading economists off all stripes from the across the world.
In a clear riposte to critics in Germany, Mr Draghi said the ECB’s 2pc inflation target is “defined for the euro area as a whole”. This necessarily means that some countries may go through bouts of inflation above 2pc to balance the system, when they are growing faster than others.
He reminded the audience that the framework was devised by Otmar Issing, the former high priest of the Bundesbank and the venerated chief economist of the ECB in its early years.
Mr Draghi said Portugal, Ireland, and Greece have slashed relative labour costs by 15pc since 2009, and have achieved current account surpluses. They are no longer “living beyond their means”.
Yet he admitted that the wrenching adjustments have cut the eurozone’s economic output and perhaps also its growth rate. “Euro area countries are using the second decade of the euro to undo the mistakes of the first,” he said.